They think it’s all over
The new hit theme in the financial markets is that the worst of the global financial crisis – ‘turmoil’ is the preferred term, since ‘crisis’ apparently has overly negative connotations – is behind us. The lead singers in this performance are the large investment and commercial banks, but they are getting support from the central banks whether in word – as from the Bank of England in a report published on Wednesday – or in deed – as from the Fed, in its 25-basis point cut and announcement of a ‘pause’, also on Wednesday.
But the same Fed statement made clear that the expected ‘pause’ in rate cutting over the coming months was both temporary and tenuous. The Fed was very determined to avoid creating the impression that its rate-cutting cycle has reached an end; rather, it left its options wide open, pending further developments. Given the ongoing rise in inflation and the lurking fear of possible further shocks that could trigger renewed ‘turmoil’, this was the prudent thing to do. Just how fluid the situation is and how quickly expectations can change may be judged from the fact that as recently as three weeks ago, the consensus view was that the Fed’s Open Market Committee meeting that concluded yesterday would cut interest rates by 50% basis points and continue to stress the threat of further weakness in the markets and real economy.
Since then, however, the financial markets have displayed increasing stability, with prices rising and spreads narrowing. This is what has prompted the outburst of optimism among market participants. But it is precisely the identity of the cheerleaders who, as noted, are the main market players that devalues the content of their cheery message. These institutions have a huge vested interest in the wellbeing of the markets, because as the markets go so do they, their profits and the obscene and increasingly controversial remuneration packages of their employees.
Furthermore, these institutions – and the central banks, for that matter – have been consistently wrong in their assessments about the depth, severity and magnitude of the crisis for the last two years. First with regard to the housing ‘downturn’, then with regard to sub-prime mortgage loans, and then on through the litany of woe and cataclysm that began in earnest last July, they have been forever claiming that the end is in sight, a turning-point is imminent and that, yes, the worst is behind us. That, for instance, is what they said after Citigroup, Merrill Lynch and UBS made their initial multi-billion dollar write-downs last October; in fact, and as more objective analysts noted at the time, these were merely the opening salvoes of a prolonged barrage of losses that will stretch on for many quarters.
Whilst there are honourable exceptions, the sad truth is that objectivity cannot be expected from analysis, whether corporate or macro, produced by major investment institutions. Even when they present a serious, balanced analysis with negative conclusions – a long piece from JPMorgan on the drab outlook for corporate profits over the next several years (an unusually long time horizon for an investment house) – you get the feeling that the punches are being pulled, so as to avoid inflicting excessive pain.
Of course, every crisis has a turning-point and if you keep predicting it, you will be right in the end. Indeed, there is a strong basis to posit that the bailing-out of Bear Stearns in mid-March may indeed have marked the climax of the financial crisis, insofar as it represented an existential threat to both markets and institutions. Since then, these have resumed a semblance of normal functioning. But that is not the same thing as saying that crisis as a whole is over – and the proof that it isn’t is the fact that spreads in the money and bond markets remain much wider than they were a year ago, or have usually been on an historical basis.
Finally, the good news from the markets must be tempered by the continued bad news from the real economy, where most key data continues to depict rapid deterioration. The supposed cheer to be garnered from the fact that US economic growth was marginally positive in the first quarter evaporates on even a cursory examination of the details: notably, inventory build-up is the most illusive form of growth, because it stems from slowing sales and portends reduced output.
In short, the financial crisis has abated, although it is too soon to know whether this is a lull or whether the storm has indeed passed. If the latter, then the focus must move to the real economy, which in the US is suffering from growing weakness which is expected to spread round the world – whilst the surge in global inflation is creating additional pressure, like an infection attacking an already weakened body recovering from a serious illness.